Price Risk Management for Cattle
Producers
 Why
worry about price risk
 Futures
 Forward Contract
 Options
 Insurance
Feedlot Profit Factors
Steer feeding profit variation explained (%)
Placement wt
<600
700-800
Fed price
58.07
50.46
Feeder price
2.30
19.31
Corn price
5.29
4.19
Feed/gain
7.22
3.55
ADG
1.36
6.31
Interest rate
1.55
-.38
Total explained
75.79
83.44
Fed Cattle Price Forecast Error, 1995-2004:
Seasonal Index and Basis Adjusted Futures
Quarters
Index
Index Futures Futures
Out
Average Std Dev Average Std Dev
1
2
3
4
-0.26
-0.37
-0.11
0.56
5.24
6.18
6.29
5.89
http://www.econ.iastate.edu/faculty/lawrence/
0.05
0.59
0.95
0.80
3.86
4.97
6.33
6.89
68% of time
16%
SD
SD
16%
Futures Market Exchanges
 Chicago
Mercantile Exchange
 Centralized pricing
– Buyers and sellers represented by brokers in
the pits
– All information represented through bids and
offers
 Perfectly
competitive market
– Open out-cry trading
– Beginning electronic trading
The futures contract
 A legally
binding contract to make or take
delivery of the commodity
– Trading the promise to do something in the
future
– You can “offset” your promise
 Standardized
contract
– Form (wt, grade, specifications)
– Time (delivery date)
– Place (delivery location)
Standardized contract
 Certain
delivery (contract) months
 Fixed size of contract
– Grains 5,000 bushels
» Corn, Wheat, Soybeans
– Livestock in pounds
» Lean Hogs 40,000 lbs carcass
» Live Cattle 40,000 lbs live
» Feeder Cattle 50,000 lbs live
 Specified
delivery points
– Relatively few delivery points
The futures contract
 No
physical exchange takes place when the
contract is traded.
 Payment is based on the price established
when the contract was initially traded.
 Deliveries are made when the contract
expires (delivery time).
Hedging definition
 Holding
equal and opposite positions in
the cash and futures markets
 The substitution of a futures contract for
a later cash-market transaction
Terms and Definitions
 Basis
– The difference between the spot or cash price
and the futures price of the same or a related
commodity.
 Margin
– The amount of money or collateral deposited
by a client with his or her broker for the
purpose of insuring the broker against loss on
open futures contracts.
Hedging Example
 April
1, a cattle feeder as 300 fed cattle to
market in October.
–
–
–
–
October futures on 4/1
Expected basis in October
Commission
Expected hedge price
$98.50
-3.25
-.15
$95.10
Hedging Example
 Now
October 1 and the cattle are ready to sell.
 Higher prices, Same basis
–
–
–
–
–
–
–
October futures on 10/1
Actual basis in October
Cash price received for cattle
Offset futures: 98.50-103.00=
Commission
Futures gain/loss:
Net hedge price: $99.75-4.65=
$103.00
-3.25
$99.75
-4.50
-.15
-4.65
$95.10
Hedging Example
 Now
October 1 and the cattle are ready to sell.
 Lower prices, wider basis
–
–
–
–
–
–
–
October futures on 10/1
Actual basis in October
Cash price received for cattle
Offset futures: 98.50-93.00=
Commission
Futures gain/loss:
Net hedge price: $99.75-4.65=
$93.00
-4.25
$88.75
5.50
-.15
+5.35
$94.10
Hedging results
 In
a hedge the net price will differ from
expected price only by the amount that the
actual basis differs from the expected basis.
 Basis estimation is critical to successful
hedging
Futures Summary
 Today’s
price for delivery in future
 Standardized contract/promise to make or
take delivery
 Contract/promise can be offset
 Several participants for different positions
 Basis estimation important to hedgers
Net Price
Hedger Position
Long Cash
Adjust for basis
Hedge
Adjust for basis
Futures
@ Maturity
Forward Contracts
 Contract
for delivery
– Defines time, place, form
 Tied
to the futures market
– Buyer offering the contract must lay off the
market risk elsewhere
– The buyer does the hedging for you
Forward contract advantages
 No
margin account or margin call
 Working with local people
 Flexible sizes
 Known basis
 Tangible
 Simple
Forward contract disadvantage
 Inflexible
– Replace price risk with production risk
– Difficult to offset
– Must deliver commodity
 Buyer
“takes protection”
– The known basis may be wider
OPTIONS
 “Options
on futures” are contracts.
 The
buyer of an option has the RIGHT (but not
the obligation) to trade a futures contract under
certain conditions.
 The
seller of an option MUST trade a futures
contract under certain conditions IF the option
buyer so desires.
Hedger’s Price Floor
 Buy
a put option with selected strike price
– Adjust for basis
– Pay premium and commission
– Floor = SP- Prem+ Basis- Comm

Establish the minimum expected price, but can
receive higher prices if they occur. The net price
is:
– Prices<Strike price = Floor price
– Prices>Strike price = Cash price – prem - comm
Hedger’s Price Floor
 In April
for cattle to sell in October
 Buy Oct put with strike price=
–
–
–
–
Premium for this strike
Expected basis
Commission
Floor price
$96.00
-$3.20
-$3.25
-$0.15
$89.40
Hedger’s Price Floor
 It
is now October and prices are $103.00
 Cash price $103.00-3.25
$99.75
 Value of put
$0
 Cost of put $3.20 + .15
-$3.35
 Net cash price
$96.40
Hedger’s Price Floor
 It
is now October and prices are $93.00
 Cash price $93.00-3.25
$89.75
 Value of put: 96.00-93.00
$3.00
 Cost of put: $3.20 + .15
-$3.35
-.35
 Net cash price
$89.40
Net Price
Hedger Position
Long Cash
Adjust for basis
Buy Put
Hedge
Adjust for basis
Strike Price
Futures
Hedger’s Price Ceiling
 Buy
a call option with selected strike price
– Adjust for basis
– Pay premium and commission
– Floor = SP+ Prem+ Basis+ Comm

Establish the maximum expected price, but can
receive lower prices if they occur. The net price
is:
– Prices>Strike price = ceiling price
– Prices<Strike price = Cash price + prem + comm
Net Price
Hedger Position
Long Cash
Adjust for basis
Buy Call
Hedge
Adjust for basis
Strike Price
Futures
Livestock Risk Protection (LRP)
Coverage
for hogs, fed cattle and
feeder cattle
70% to 95% guarantees available,
based on CME futures prices.
Coverage is available for up to 26
weeks out for hogs and 52 for cattle.
Size of Coverage
Futures and options have fixed
contract sizes
– Hogs: 400 cwt. or about 150 head
– Fed cattle: 400 cwt. or about 32 head
– Feeder cattle: 500 cwt., 60-100 head
LRP can
be purchased for any
number of head or weight
Projected Net Revenue per Head
Cash Selling Price, $/cwt.
$/head
$89.00
$94.00
$99.00
$104.00
$109.00
$114.00
$119.00
$124.00
$250
$200
$150
$100
$50
$0
($50)
LRP highest level
PUT Options
Hedge
No Risk Protection
Projected Net Revenue per Head
Cash Selling Price, $/cwt.
$/head
$89.00
$94.00
$99.00
$104.00
$109.00
$114.00
$119.00
$124.00
$250
$200
$150
$100
$50
$0
($50)
LRP highest level
PUT Options
Hedge
No Risk Protection
Some Risks Remain
LRP,
LGM do not insure against
production risks
Futures prices and cash index prices
may differ from local cash prices
(basis risk)
Selling weights and dates may differ
from the guarantees
Expiration Date of Coverage
LRP ending
date is fixed. Price
may change after date of sale.
Hedge or options can be lifted at
any time before the contract
expires.
Livestock Gross Margin
Insures a “margin” between revenue and
cost of major inputs
Hogs
Value of hog – corn and SBM costs
Cattle
Value of cattle – feeder cattle and corn
Protects against decreases in cattle/hog
prices increases in input costs
LGM-Cattle
Yearling GM = 12.5 x Basis adjusted LC futures
- 7.5 x Basis adjusted FC futures
- 57.5 x Basis adjusted Corn futures
Calf GM = 11.5 x Basis adjusted LC futures
- 5.5 x Basis adjusted FC futures
- 55.5 x Basis adjusted Corn futures
Summary
 Price
risk management is essential
– Fed, feeder and feed
 Tools
are available to manage risk
– Do not guarantee a profit, only a tool to manage
price risk
– Knowledge and skill are important
 Insurance
products are relatively new
– Useful where size and simplicity are important